Adjustable Rate Mortgages: The Pros and Cons to these Tempting Loans

Posted by Wayne Long on Wednesday, December 16, 2009 at 4:23:24 PMBy Wayne Long / December 16, 20094 Comments

An adjustable rate mortgage by definition is a mortgage where the interest rate is periodically adjusted. These mortgages are very tempting when your loan officer tells you that you can receive a lower interest rate than a fixed rate mortgage with the possibility of the rate going even lower when adjusted. These mortgages can pose a huge benefit to you and your pocketbook if you have done your homework and know the specifications of each loan available to you.

The trick to an ARM(adjustable rate mortgage) is to have all the information and solicit outside help if the terms are unfamiliar to you. If you plan to own your home for 5 years or less, this could be the best loan for you: if you choose the right one. The pros and cons to an adjustable rate mortgage may differ by each plan and each loan officer. So, again be sure to do your research and don’t make hasty decisions.

Pros to all Adjustable Rate Mortgages:• The interest rate usually starts out lower than a fixed rate mortgage• You could pay less than a fixed rate mortgage over a long period of time if the interest rate stays about the same or drops even lower

Cons to all Adjustable Rate Mortgages:• There is the possibility that interest rates could rise and so would your monthly payments

Good things to know about Adjustable Rate Mortgages:• Your interest rate is made up of two parts: the index and the margin. The index is a measure of interest rates and the margin is an extra percentage the mortgage lender adds. In other words if the index is 4% and your lender’s margin is 2% your interest rate will be 6%.• Some ARMs have interest rate caps. The interest rate cap can be a periodic interest rate cap or a lifetime interest rate cap. A periodic interest rate cap will put a cap on how much your interest rate can increase/decrease after each adjustment period. A lifetime interest rate cap will put a cap on how much your interest rate can increase/decrease over the life of your loan. Some ARMs have both.• Some Adjustable Rate Mortgages will allow you to lock in a very low percentage rate for a certain period of time. If you choose an ARM with a fixed rate for 3-5 years and are in the military or are planning to sell your home during that time you could end up paying significantly less than you would with a fixed rate mortgage during that period of time.

Things to watch out for when choosing an Adjustable Rate Mortgage:• Some lenders offer discounted interest rates for a short period of time during the loan. These discount points may sound great in the beginning but may make you pay in the end. When the discount rate runs up, the monthly payment may increase greatly and come as a huge shock to you. • Interest Only ARMS will also give you a break in the beginning because you will only pay on the interest of the loan for the agreed upon time. Make sure you are prepared for the dramatic increase in payments once the time runs up and you must start paying back the principal as well. Also, keep in mind that the principal builds up so the longer period you pay interest only the higher your payments will be when you start paying principal as well.• Payment caps will put a cap on how much your payment can increase after the adjustment period. This may seem like a great protection to you; however, it can cause negative amortization. Negative amortization occurs when you continue to owe more on your loan even though you are making your regular monthly payments. For example: if your payment cap does not allow you to pay the full interest due each month, the interest owed will be added to your debt.• Payment Option ARMswith a limited or minimum payment may also lead to negative amortization. If your payment does not cover the interest amount due each month, it will be added to the amount of the loan and you could end up owing more on the house than the purchase price.• Pre-payment Penalties are applied to some loans and put a penalty amount to be paid by the borrower if they payoff, sell, or re-finance their home before a certain period of time.• Conversion fees are set in some ARMs to allow the borrower to convert the loan to a fixed rate mortgage at certain times but may specify a higher interest rate or a fee to be paid at the time of conversion.

Discussion

#1 By Jim Meadows at 12/24/2017 1:30 AM

Great information!!! My girlfriend is a realtor and I hope she has my back on these issues!!!!!Hope everyone is well!!!!!

I am not a lender but one really has to wonder if some of these financing "schemes" should even be legal anymore given the mortgage and housing crisis the country has been through and will still take YEARS to recover from!

Hilton Head real estate market is still seeing some of these once in a while. You've got a well written article here and it should be required reading for those thinking about getting into one of these loans. Like anything else if a borrower knows what the real deal is they are in far better shape.